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Despite Losses from Investment with Madoff, Investor May Not Rescind Swap Agreement with HSBC

In the ISDA agreement, Wailea, a sophisticated business party, expressly disclaimed reliance on statements by HSBC regarding the investment.

Under New York contract law and applicable precedent, the written agreement governs the relationship between the parties.

The U.S. District Court for the Northern District of California dismissed with prejudice all claims by Wailea Partners, LP (Wailea), a California investment firm, against HSBC Bank, USA, N.A. (HSBC) for rescission of a total return swap agreement (Agreement) and return of approximately $15 million of collateral Wailea posted to HSBC. HSBC synthetically invested Wailea's money in a fund that used Bernard Madoff as the exclusive asset manager on the basis that the fund would use a specific investment strategy. Once Madoff's Ponzi scheme was uncovered and the investment failed, Wailea sued HSBC asserting five claims for rescission, including mutual and unilateral mistake, innocent misrepresentation, and failure of condition precedent. Wailea contended that HSBC had been aware of a risk of fraud at Madoff's firm and that Madoff was not using the investment strategy Wailea intended to get exposure to. The Court agreed with HSBC's motion to dismiss and found that the clear language of the Agreement prevented Wailea's claims from succeeding.

Background–the Disputed Swap Agreement

In May 2007 Wailea and HSBC began negotiating the Agreement through which Wailea would gain exposure to hedge funds that utilize the so-called "split-strike conversion" (SSC) trading strategy. Under the terms of the total return swap, Wailea would receive a return based on the performance of the reference asset, in this case a fund called Senator Equity Segregated Portfolio One (Senator Fund). The parties selected the Senator Fund because most of its capital was deposited with Bernard L. Madoff Investment Securities LLC (BLMIS), which purported to use the SSC trading strategy. Between October 2007 and December 2008 the parties amended the Agreement several times to increase the maximum notional amount and Wailea periodically adjusted the amount of collateral it provided to HSBC, which had the effect of adjusting the amount of Wailea’s synthetic investment in the Senator Fund. In total, Wailea transferred $15,970,000 in collateral to HSBC. Wailea alleged that HSBC suspected Madoff's involvement in fraud since 2005 because it had hired the auditing firm KPMG to review BLMIS’s business for "fraud and related operational risk." KPMG did indeed find several risks of fraud, including a failure to segregate client funds and deviation from the SSC trading strategy, both in a 2006 report submitted to HSBC and a subsequent report issued in March 2008. In the second report, KPMG pointed HSBC to risks of "falsification of client mandates, embezzlement of client funds, and diversion of client funds for Madoff's personal gain." Following this report, HSBC affiliates began a mass liquidation of their assets in BLMIS hedge fund clients, including the Senator Fund in which HSBC liquidated substantially all of its assets. When Wailea asked about the HSBC affiliates' liquidation efforts, HSBC told Wailea "that there was no reason for concern and that the redemptions were made for 'market reasons.'" HSBC did not disclose the contents of the KPMG reports to Wailea.

Choice of Law–the ISDA Agreement Prevails

Wailea argued that since it was disputing the very formation of the contract, the contractual choice of law provision of the Agreement should be inapplicable and California law should apply. HSBC contended that pursuant to the choice of law clause in the Agreement, New York law should apply to Wailea's first four claims. The Court agreed and determined that California choice of law rules strongly favor the application of contractual choice of law clauses and New York law was thus applicable to the first four claims.

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